Bowman begins his task by gathering the following current market statistics: • 1 year U.S. Interest Rates = 8% • 1 year U.K. Interest Rates = 10% • 1 year /₤ forward rate = 1.70 • Current /₤ spot rate = 1.85 Bowman knows that if the forward rate is lower than what interest rate parity indicates, the appropriate strategy would be to borrow: A) pounds, convert to dollars at the forward rate, and lend the dollars. B) pounds, convert to dollars at the spot rate, and lend the dollars. C) dollars, convert to pounds at the forward rate, and lend the pounds. D) dollars, convert to pounds at the spot rate, and lend the pounds.

What are the forward and spot on? Formatting got messed.

D?

buy forward, sell spot borrow UK, buy dollars at the spot rate, lend the dollars -> convert back using forward rate B

Damn, makes sense.

I guess B but seeing Nibs answer I think I might be wrong.

sorry, 1 yr fwd /pound = 1.7 current /pound spot=1.85

Can somebody walk me through this like I am a 2 year old?

Your answer: B was correct! If the forward rate is lower than what the interest rate parity indicates, the appropriate strategy would be: borrow pounds, convert to dollars at the spot rate, and lend dollars.

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Step 1: Calculate the covered interest rate using the formula given below: (Forward/Spot)*(1 + Rfc) Step 2: If the above value is greater than (1 + Rdc) then borrow domestic lend in foreign, and if above value is less than (1 + Rdc) the borrow foreign and lend in domestic.

covered interest rate parity: F = S*(1+rDC)/(1-rFC) if Fmarket < Ftheor -> you should buy F and sell S to lock arbitrage profit. To sell S (UK) you should borrow UK, buy US and lend dollars

i got lucky on my guess. i know how to compare domestic rate to hedged foreign rate, but not sure how to answer this ? w/out knowing the rates exactly, b/c they’re really not necessary. i was hoping you geniuses could answer that.

kabhii Wrote: ------------------------------------------------------- > Step 1: Calculate the covered interest rate using > the formula given below: > > (Forward/Spot)*(1 + Rfc) So this the hedged foreign right? > > Step 2: If the above value is greater than (1 + > Rdc) then borrow domestic lend in foreign, and if > above value is less than (1 + Rdc) the borrow > foreign and lend in domestic. Borrow cheaper…

mwvt9 Wrote: ------------------------------------------------------- > kabhii Wrote: > -------------------------------------------------- > ----- > > Step 1: Calculate the covered interest rate > using > > the formula given below: > > > > (Forward/Spot)*(1 + Rfc) > > So this the hedged foreign right? Yes.

I get 1.08 = 1.01 so borrow pounds, convert to dollars etc . . . That makes sense, but how does the forward rate effect this? I am missing something.

I agree with B - but I always have problems with these. I always set the equation as such using DC/FC convention: 1+dom.rate = F/S * (1+for.rate) If I’m correct, the right side is the hedged foreign rate. All you need to know is borrow at the lower rate. In this case you borrow pounds. The rest comes easy. Please tell me I got it or else I’m crushed…

Geez I type slow…